U.S. Government Bonds Pull Back but Pare Losses After Auction

Auction attracts strongest overall demand since November

U.S. government bonds pulled back Tuesday as strong housing data and higher stocks sapped investors’ appetites for safe assets.

But the bond market clawed back most of its price decline in the afternoon following a strong two-year auction.

Yields on short-term debt are highly sensitive to the Fed’s policy outlook. The two-year note’s yield has climbed this month as a number of Federal Reserve officials warned that a rate increase in June isn’t off the table.

Tuesday’s data showed sales of new homes rose at the fastest pace in more than eight years in April, which supported the central bank’s case in normalizing monetary policy. Before the auction, the yield reached the highest intraday level since mid-March. Yields rise as bond prices fall.

Higher yields attracted buyers into the $26 billion sale, the first leg of this week’s new government note auctions. The direct bidding, which includes buying from large U.S. institutional investors, jumped to 32.5% -- the second largest amount of all time behind the 38.2% figure in the October 2012 sale, according to Jefferies LLC.

Foreign demand was also firm as reflected by the 49.8% indirect bidding. While the notes were sold at a slim yield of 0.92%, that represents a steal compared with negative yields investors get from comparable government bonds in Germany and Japan.

The strong auction surprised some bond traders who thought that bidding should be constrained given the Fed’s jawboning lately.

Yet money managers have said the bond market has adjusted to the prospect of a moderate rate increase by the Fed. The central bank’s tightening campaign will continue to be slow. That, along with much lower yields overseas, continue to keep a lid on U.S. bond yields.

The auction demand was “unreal,” said Tom di Galoma, managing director at Seaport Global Securities LLC. “Yields are getting too cheap. There is a lot of cash out” chasing fewer high-quality government debts.

The auction results gave the bond market a lift, with bond prices paring losses. The yield on the benchmark 10-year note settled at 1.859%, down from its session peak of 1.88% and compared with 1.840% Monday.

Fed Chairwoman Janet Yellen will speak at Harvard University on Friday and on June 6 before the World Affairs Council of Philadelphia.
Photo:
Zuma Press

The two-year note’s yield closed at 0.909%, down from its session high of 0.93%. The yield was 0.899% Monday.

The bond market faces more supply later this week. A $34 billion sale of five-year notes is due Wednesday, followed by a $28 billion sale of seven-year notes Thursday.

Selling short-term debt and migrating to longer-term bonds has picked up momentum over the past week as investors adjusted their portfolios to the risk of a near-term tightening act by the central bank.

As a result, the yield premium investors demand to hold the 10-year Treasury note relative to the two-year note has fallen lately. On Tuesday, the premium at one point hit 0.93 percentage point, the lowest level since late 2007.

In the bond world, a lower premium is known as a flattening yield curve. In the past it was widely interpreted by investors as a sign that the U.S. economy would be losing momentum due to the Fed’s tightening policy.

Yet this time, money managers and analysts say the flattening curve is more a reflection of foreign investors’ struggle to obtain income in light of negative yields in Japan and Europe. As they buy long-term U.S. bonds that offer one of the most attractive yields in the developed world, it helps keep long-term U.S. bond yields near all-time lows, even as a robust labor market and some signs of uptick in inflation would have sent yields higher.

The U.S. economic growth is “strong enough” to withstand one or two rate increases from the Fed this year, and the bond market is adjusting to the risk, said Lynn Chen, senior portfolio manager at
Aberdeen Asset Management
which had $420.9 billion in assets under management at the end of March.

Interest-rate futures—a popular tool for hedge funds and money managers to place bets on the Fed’s future policy moves—showed Tuesday that the odds of an interest-rate increase at the Fed’s June 14-15 policy meeting were 34%, according to CME Group. A month ago the probability was zero.

The odds for a rate increase at the Fed’s December meeting were 81%, up from 46% a month ago.

Fed Chairwoman
Janet Yellen
will speak at Harvard University on Friday and before the World Affairs Council of Philadelphia on June 6. The June speech will come three days after the May jobs report, and just over a week before the Fed’s June policy meeting.